The IDRs of the four government banks are driven by a high probability of extraordinary government support if required given their high systemic importance.

These banks account for close to 32% of the system assets and deposits backed by a pan-India franchise of over 27,000 branches as of the financial year ended March 2012 (over 33,000 including SBI's five associate banks).

Compared with the government banks' covered in this review, Canara's VR downgrade reflects structural challenges in the bank's funding and asset quality, which are unlikely to be addressed without near-term implications on growth and, potentially, on market share.

In particular, Canara has higher risk concentration to the troubled infrastructure sector including state electricity boards (SEB) and a weaker funding profile.

In general, government banks have large concentrations in the infrastructure sector, where industry challenges including fuel supply issues, low tariffs, and high interest cost are leading to large-scale restructuring in areas such as SEBs, power projects and aviation.

Fitch believes that the reported non-performing loans (NPLs) do not completely reflect these risks as their calculation does not include restructured loans. Fitch believes that the potential for further loan restructuring is highest for Canara and is a negative for its asset quality given its weak specific provision cover of only 15% at FYE12.

Bank of Baroda is also vulnerable to more loan restructuring but this is mitigated by its asset quality track record and performance - the strongest among large government banks in the last five years. Furthermore, BOB's specific provision cover - along with SBI's - is among the highest for large government banks at 59% and 64% respectively.

SBI - despite its high NPLs - has seen a consistent increase in specific provision cover in the last four years and has the lowest proportion of restructured assets relative to peers. Fitch estimates that stressed assets (NPLs plus restructured loans) ratios for SBI and BOB stood at 6.7% and 6.4% for H1FY13 despite wide divergence in their reported NPLs of 5.2% and 2% respectively.

The stressed assets ratio was the weakest for PNB at 11.7%. The VRs for SBI, PNB and BOB factor in their stable funding, asset diversity and reasonably high pre-provision profitability.

These strengths should help the banks to withstand increase in credit costs even under stress without materially impairing their capitalisation.

Canara, on the other hand, has lower overall profitability relative to these peers due to weaker margins, which are a function of its higher-cost funding profile.

Despite funding challenges posed by rising interest rates over the last two years, low-cost deposits per branch have increased for large government banks, except Canara, and have helped maintain deposit stability despite migration towards term deposits.

Capitalisation is considered strong for the four banks, backed by timely capital support from the government and sound quality of capital.

The large banks are expected to account for a sizeable share of the Indian banking system's capital requirement under Basel III.

Raising capital may be a challenge at a time when most banks are also likely to seek capital, which is between FY16-FY18. The ratings of the tier 1 subordinated bonds and upper tier 2 bonds are consistent with the approach taken for other similar performing securities based on Fitch's criteria.

BOBNZ's ratings reflect Fitch's expectation of continued strong support from BOB, given 100% ownership and management control.

The IDRs for all four banks and the VRs for SBI, PNB and BOB, which are capped by the sovereign's IDR, would be sensitive to a downgrade of the Indian sovereign. Furthermore, the VRs would be sensitive to weaker operating conditions that materially impact asset quality indicators beyond Fitch's current expectations.